Advanced Technical Analysis

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Note: the following analysis is formulated as an assimilation of Fibonacci, DeMark, Elliott Wave and other technical indicators. It is offered as education and not intended as advice in any way.

Summary:

Yesterday's substantial bounce higher alters the wave count we had been working with as stops were triggered in all three indices. For the last several sessions we had been under the impression that the impulse wave down from 4/27 had completed a 4th wave upward correction (at the 5/19 high) and was set to decline in a 5th wave toward our lower Fibonacci targets. The overlapped price pattern since the 5/12 lows lent considerable confidence to this assessment. Today's move higher, by moving above the 5/19 highs, negates that conclusion. The question is: does it negate the call for a final 5th wave down to complete the impulse wave down that started on 4/27? The short answer is: not yet. The internals of yesterday's move was confirming the advance: breadth was a record at +2,231 and higher than all readings since 5/2/2001; up vs down volume was 8.25:1, better than all readings from 12/29/03; volume expanded too, edging up 20% to 1.5B on the day. But the most important technical observation we can make about the price pattern since 5/12 has been the overlapped nature of prices. In corrective bounces, prices overlap because they "struggle" to gain ground. In movements with trend, prices do not overlap and trace out 5 waves in an impulse pattern. It is very difficult to see anything but overlap in the price record from 5/12, which is why we have been, and continue to be, of the mind that this is a 4th wave corrective bounce. Our initial conclusion then on yesterday's action is that the 4th wave upward correction is evolving in a more complex (read: overlapping) fashion for the SPX and the INDU.

The NDX pattern is far less clear so we're focusing for now on the SPX and INDU. For all indices, the very short term shows that a "5" wave move up from yesterday's 10AM low is or could shortly be complete; hourly Demark trend exhaustion indicators were triggered at the close for the SPX and INDU. What kind of (and if) pullback prices see once "5" up is complete from the yesterday 10 AM lows will be important to determining if this upward correction is in fact a 4th wave correction that will ultimately resolve lower or if it is the start of a new impulse move higher. No clear picture presents itself until we get a more confident conclusion to whether this up move is a 4th wave correction or is the start of a new impulse wave higher that will last a week or more and work off the daily oversold conditions that are in place. Given the high degree of overlap in particular for the SPX and INDU, the long side could be quite risky here. As well, since we cannot yet identify a clean conclusion to a potential complex 4th wave upward correction, the short side remains problematic as well in our view.

The Role of Probability in Technical Analysis

We have touched on the role that probability plays within the system of technical indicators we employ only tangentially. Given yesterday's surprising bounce and the fact that it came when our stated confidence level was "high" for a move down, now seems an appropriate time to flesh out the idea a touch more.

As readers are hopefully aware by now, the combination of Elliott wave, Fibonacci, and Demark indicators we employ is the heart of the technical analysis we use. Momentum measures, channel trendlines, market internals (breadth, ticks, volume), and sentiment (put/call ratios, etc.) are all add-on classic technical analysis tools that help confirm or deny the conclusion we reach through the use of the infinitely more important Elliott wave, Demark, and Fibonacci work. The truly valuable insight, then, is offered by the Elliott, Fibonacci, and Demark indicators.

Having said that, these three important indicators of course offer only a probabilistic insight, which is to say that, because each are trend exhaustion/reversal indicators (as opposed to most classical technical analysis tools which are entirely trend following), they can only provide insight about the most probable price levels and times for (bullish or bearish) trends to exhaust themselves. When, for example, a large impulse wave ends and over the next several sessions highly overlapping price action takes prices back to an important Fibonacci high resistance point (say 50% or 61.8%) of that impulse wave down, the probability is much greater that prices will break down from near that resistance point than the probability that prices will accelerate higher.

The analogy that we often try to conceptualize is that of the blackjack table: if the house has drawn 16 and you hold a 20, the odds are decidedly in your favor that you will win the hand, owing to the fact that the house must draw another card. With many more cards in the deck that would bust the house's hand, the probabilities of a winning hand are squarely on your side. Based on the probabilities alone, you should wager decidedly more on such hands, given the chance, than on hands where the odds are not quite as one-sided in your favor. Over time, such probability-adjusted wagering will net greater profits. This is the entire idea behind card counting.

Employing Elliott wave, Fibonacci, and Demark indicators is much the same, to us anyway, as counting cards. Though it does not offer prescient insight into the likely direction of stock prices, it does offer a probability for the binary question: higher or lower? Overlapping corrective price action that travels to Fibonacci resistance of a previous impulse wave and does so with momentum divergences presents a high probability of trend exhaustion near those Fibonacci resistances. Non-overlapping, impulsive price action confirmed by momentum that has not yet completed a full "5" waves presents a high probability of continuing in the direction of impulsive action. There are, of course, combinations of impulsive and corrective price action (such as right now in the NDX) that complicate matters and make any judgment suspect. It's the equivalent of drawing a 17 to the dealer's 12 in blackjack. At such times it pays to wager less and await a better draw.

In our mind's eye, we tend to see a classic bell curve of probabilities at any given session for the stock market. On the far left hand side of the bell curve, > 3 standard deviations away from mean, is the minute probability (Some traders use a baseball analogy: waiting for the "fat" pitch or the perfect trade setup. For ourselves, we like the bell curve analogy; we're aiming for 1 standard deviation or less. We won't always get there, but that doesn't mean the indicators are flawed. It just means the dealer has bucked the odds. Now on to the specifics of yesterday's action.

The SPX opened lower and bounced from 10AM for the rest of the day on increased volume, record breadth, but on diverging momentum (MACD and ROC). The overlap from 5/12 gave way to an impulse move from 10AM yesterday that took out our stop levels and that looks nearly complete as of yesterday's close. So, since our levels were violated on the move, the question becomes: is the 4th wave correction we had assumed was ended not complete yet or is this the start of a new impulse move higher that will work off the daily oversold conditions that are present?

In order for this latest move to be a new impulse move higher, it should be preceded by impulsive action. As we have been observing, the action from 5/12 has been anything but impulsive, as the overlap in prices has been fairly clear. In addition, for the impulsive move to continue, prices need to remain above 1106 for the next several sessions or else, again, more overlap will occur that will negate any impulsive interpretation of the price pattern. As you can see, the case for this being an impulsive move from the 5/12 lows is tenuous at best.

The case for this move from 5/12 being a corrective 4th wave are still far better. The overlap in prices and the lack of any clearly impulsive moves (save for the upward move from yesterday at 10AM) make this the more high confidence call. But because this 4th wave correction has now taken on a highly complex pattern (i.e. it is not a typical flat or a typical zig-zag correction at this stage), determining where it will end is now very difficult.

About the only corrective pattern we can still "see" is that of an ABCDE triangle, with the A wave ending on the 13th, the B on the 17th, the C on the 19th, the D on the 20th, and the E wave ended yesterday or this AM. One can see a clear upper trendline break with yesterday's afternoon action; oftentimes, E waves within triangles do just that, break above or below their respective trendlines. Only if prices moved lower right away today would this 4th wave corrective interpretation be valid. And a target of 1066-1072 remains largely in place if this bearish interpretation is correct. Other more complex corrective patterns are also possible. If, however, prices maintain support above 1106 and continue to move higher for several straight sessions, could we conclude that the 5/12 lows were a very important pivot.

As a result of the low confidence in the pattern and the technical indicators here, no clear picture on a risk / reward scale presents itself. The overlap from 5/12 makes the long side exceedingly risky while our inability to identify a clean end to a potential 4th wave correction makes the short side risky too.

The Nasdaq 100 (NDX)

The NDX bounced from 10AM as well yesterday, adding more than 2% in the process on 20% more volume and solid breadth. Momentum in the NDX's case was largely confirming the price highs (not on shorter term charts but on 21 min charts and larger). Hourly Demark trend exhaustion indicators were not yet triggered as of yesterday's close.

By moving above the 1425.49 stop level, the NDX has negated a previous conclusion that a 4th wave corrective bounce had completed at the 5/19 highs. What pattern has been created here however, remains far more elusive than in either the SPX or the INDU. Since so much of the price action in the entire month of May has been overlapping, it is difficult to say where previous impulse waves have ended and where new ones have started. As a result of this, about the only thing we can reasonably conclude is that the probability for a sustained advance higher is slim but so too is our ability to discern where or when this current bounce will end.

What we can identify from the recent price pattern is that an impulse wave took prices off the 5/17 lows to the 5/19 highs, another impulse wave took prices from the 5/19 highs to the 5/20 lows, a mess of overlapping corrective action took prices from the 5/20 lows to the 5/25 lows, and another impulse wave up took place from 10 AM yesterday to a possible completion today. There are so many ways to interpret this action, both bullish and bearish, that neither the bullish nor bearish interpretation should be relied on. As we have said before, the NDX cannot have a life of its own apart from the SPX and INDU so while we cannot be specific about the pattern in the NDX, we must rely on the SPX and INDU to guide us toward "seeing" the NDX pattern. Once the SPX and INDU pattern clears itself up, it may be possible to come to a clearer conclusion about the NDX. For now, the NDX technical conclusion remains too cloudy to bear fruit.

In order for the bullish interpretation of the NDX to remain valid, prices cannot overlap with the 1427.51 price level or that would present yet another point of overlap and nullify the option that this is a new impulse wave up from 5/17. If prices do overlap that level, the bearish interpretation will take on new life. For now we must wait and see if that important level is overlapped in future sessions and wait too to see what the SPX and INDU do.

The INDU has been the weakest of all of the indices, lagging advances and leading declines. It should be no surprise that the INDU shows the most overlap in prices since the 5/12 lows, with lower and higher channel trendlines clearly containing prices within a 2.3% band over that timeline. To the degree that the 4th wave corrective interpretation is the right one, the INDU has the technical pattern that most substantiates this conclusion. In sum, the price action in the INDU is much more likely corrective than impulsive; to label the move from the 5/12 lows as impulsive would be to accept a far less probable Elliott wave pattern than the pattern that suggests it is a corrective 4th wave. So the bears' hopes for a 5th wave lower to our cited supports of 9770-9824 remains bound up with the INDU and the SPX. The bulls' hopes remain tied to the fate of the NDX.

If the 4th wave correction in the INDU ended or is about to end with a minor 5th wave from the 10 AM lows from yesterday, traders should wait to confirm a trend change with a small degree "5" wave impulse move down from whatever high is struck today (if it wasn't struck yesterday).

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